As part of the recently enacted, Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA)1, Congress included an unanticipated tax provision possibly providing U.S. taxpayers with greater ability to defer the inclusion of active foreign earnings in their U.S. income tax returns. The provision sunsets after three years, so prompt attention is suggested. The tax provision may also help U.S. multinational companies create more tax efficient operations overseas. To understand the impact of this new rule, a brief explanation of a U.S. shareholder’s U.S. taxation of foreign earnings and distributions will be discussed, as well as possible planning opportunities.
Subpart F Rules
As a practical matter under U.S. tax principles, income earned by a foreign corporation is generally not subject to U.S. income tax unless: 1) the corporation satisfies the requirements for being a controlled foreign corporation (CFC)2; 2) the income falls into a category of “Subpart F income;” and 3) no exception applies.3 If the income earned by a foreign corporation meets all of these requirements, a U.S. shareholder of a CFC must include in gross income its pro rata share of the CFC’s income classified as Subpart F income, regardless of whether the CFC repatriates the income to the U.S. One type of income targeted by the anti-deferral Subpart F rules includes Foreign Personal Holding Company Income (FPHCI), which includes dividends, interest, rents and royalties received by the CFC. For example, if a U.S. taxpayer owns CFC1 and CFC1 owns CFC2 with CFC2 paying a dividend to CFC1, it is FPHCI to CFC1, absent an exception. The inclusion of this income category is the focus of new Section 954(c)(6).
New Section 954(c)(6)
TIPRA4 added Section 954(c)(6) to the Code which “looks through” to the underlying income that relates to certain payments between related CFCs when determining their U.S. tax treatment. Specifically, the CFC look through rule provides that dividends, interest, rents, royalties received or accrued by a CFC from related5 CFCs attributable to non-Subpart F income of the payor CFC will not be treated as FPHCI to the recipient CFC under new Section 954(c)(6). As such, it won’t be Subpart F income to the U.S. shareholder. Prior to the enactment of Section 954(c)(6), these types of payments would have been classified as FPHCI absent another exception, and thus included in gross income in the U.S. shareholder’s U.S. income tax return. The new law changes this treatment and allows for U.S. income tax deferral, for three years.
Structures to Better Manage Foreign Tax Credit Pools
A common structure currently used by US multinational groups to reduce FPHCI is to own their foreign companies through a foreign holding company CFC and electing to treat the foreign companies as foreign disregarded entities for U.S. tax purposes. In these structures, the foreign companies typically pay dividends, interest, rents and royalties to the foreign holding company CFC to provide efficient movement of funds within in the group while reducing the exposure to subpart F income.
This is accomplished because the foreign corporations owned by the foreign holding company CFC are considered divisions of the foreign holding company CFC and the distributions are thus not considered dividends paid to the shareholder but rather intra company transfers. If the foreign companies did not elect to be treated as foreign disregarded entities, those payments would be treated as FPHCI rather than payments among divisions.
This structure has foreign tax credit implications in addition to avoiding FPHCI. Under this structure, the net incomes from the disregarded entities are aggregated in the foreign holding company CFC. The effect of which is to blend the earnings and profits and foreign tax pools of the various entities, which may vary from high and low tax foreign jurisdictions. While the use of a foreign personal holding company structures with many disregarded entities may be very effective for addressing Subpart F issues, it may sacrifice efficient foreign tax credit utilization to the extent the structure blends the foreign tax rates of the disregarded entities. Consequently, a dividend paid by the foreign holding CFC to a U.S. shareholder will generally be accompanied by a foreign tax credit utilizing the blended tax pool, which may not be ideal.
New 954(c)(6) eviscerates the need to check the box because the CFC can make deductible interest, rent or royalty payments from a high tax jurisdiction active company to a low/no tax jurisdiction related CFC without incurring subpart F income and thus avoiding a blended earnings and profits and foreign tax pool. Companies can instead use separate chains of CFCs that earn active income and pay dividends without incurring FPHCI because of new Section 954(c)(6). It can also achieve more effective foreign tax credit planning on active CFC earnings since it can pick and chose which foreign companies to include in its earnings and profits and foreign tax credit pools.
Local Country Planning
There may also be local country tax reduction strategies that may be more facilitated under the new provision. For example, a foreign invested enterprise under current Chinese law may receive a refund of the taxes paid on a dividend if the foreign invested enterprise distributes a dividend to its foreign parent and the foreign parent reinvests the dividend back into the foreign invested enterprise. Prior to TIPRA, this dividend would have been subject to the subpart F regime if the foreign parent was a CFC and thus creating a cost in the U.S. TIPRA may now alleviate the U.S. tax costs for the strategy because the dividend may not be considered FPHCI under Section 954(c)(6).
Timing is Critical
Although enacted in May 2006, the effective date of the Section 954(c)(6) is limited to the tax years of CFCs beginning after December 31, 2005, and before January 1, 2009. The sunset of the provision is extremely important in considering planning and future avoidance of FPHCI. Also, some U.S. shareholders with CFCs that have already received FPHCI payments from related CFCs earlier this year may be able to avoid Subpart F income inclusion for these payments because the 954(c)(6) applies to tax years after December 31, 2005.
The new legislation also provides the IRS and Treasury with broad authority to curb any perceived abuse of the provision. IRS and Treasury have not yet defined what would constitute abuse. U.S. taxpayers should take this into account in doing any planning involving Section 954(c)(6).
New Section 954(c)(6) may provides greater flexibility to U.S. based multinational in reducing current U.S. taxation on active CFC earnings. However, a U.S. taxpayer looking to take advantage of this new rule must weigh the cost that might be associated with unwinding the structure if Congress doesn't extend the provision past 2009.
Whether the CFC look through rule will be useful for a given taxpayer with respect to future planning will need to be determined on a case-by-case basis. The benefits of restructuring for three years must be substantial enough to warrant the restructuring.
Todd B. Reinstein
1 P.L. 109-222.
2 In general, a CFC is a foreign corporation which is more than 50% owned (directly or indirectly) by U.S. shareholders, each of whom own 10% or more of the voting stock of the corporation Section 957.
3 Some of the exceptions include the same-country exception, the high-tax exception, and the de minimis exception.
4 P.L. 109-222, Section 103(b)(1).
5 Related person is defined in Section 954(d)(3) as more-than-50% common control. One issue that is unresolved is whether 954(c)(6) provides relief to the recipient CFC if it is related to the payor CFC at the time of the payment but unrelated at the time the income associated with the payment was earned by the payor CFC.